Lesson 9 of 11
EV = MV of debt + MV preferred equity + MV common equity - Cash and investments
Cash and investments are netted out because these items reduce the net cost of purchasing the company.
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization
EBITDA is commonly used to approximate operational cash flows that are available to suppliers of debt and equity capital
EV/EBITDA ratio is done on a total and not per share basis as it reflects value for all suppliers of capital.
Positives of EV/EBITDA
Can be used when comparing firms with different degrees of financial leverage because the P/E ratio reflects value after interest has been paid.
The ratio will help make companies with high, but varying degrees of depreciation and amortization more comparable.
EBITDA is less likely to be negative than earnings.
Negatives of EV/EBITDA
EBITDA can overstate operational cash flows in instances where working capital is growing.
EBITDA will not reflect variances in revenue recognition practices across companies, and this impacts cash flow from operations.
EBITDA is not as suitable for total firm valuation as Free Cash Flow to the Firm.
Justifiable EV/EBITDA ratio: as FCFF rises, the multiple will increase; as WACC rises, the multiple will decrease.